How U.S. ETF Managers Should Respond to PRIIPs

How U.S. ETF Managers Should Respond to PRIIPs

By Adrian Whelan and Ryan Sullivan, Brown Brothers Harriman
Originally published at the On the Regs blog

New regulatory requirements for U.S. ETFs selling to E.U. investors have caused some providers to seriously consider launching UCITS ETFs to take advantage of a growing opportunity.

The global regulatory landscape for exchange-traded funds (ETFs) continues to shift and the impact to U.S. companies who have European investors in their ETFs are beginning to reveal themselves. A new European regulation, Packaged Retail and Insurance-Based Investment Products (PRIIPs), which took effect January 1, requires additional disclosure documents, Key Investor Documents (KIDs), for funds offered to certain E.U. retail investors. The new requirements are beginning to impact sales of U.S.-based ETFs in the E.U.

Much like MiFID II rules, which have had extra territorial impact on U.S. funds, PRIIPs rules result in inconsistencies with some U.S. regulations. This leaves U.S. ETF providers to determine how to best continue satisfying E.U. investors’ needs, while also complying with both U.S. and E.U. regulations. E.U. domiciled ETFs could be the answer.

Unintended Consequences

Since its inception, industry reaction to PRIIPs has been consistently unfavorable on both sides of the Atlantic due to a couple of key provisions.

One such provision that impacts both E.U. and U.S. managers is the calculation methodology required for a mandatory disclosure of portfolio transaction costs. The way PRIIPs prescribes that disclosure has resulted in confusion across the industry. The disconnect relates to the use of a benchmark known as “arrival price” to calculate “slippage cost” which represents the difference between the price of an asset immediately before the order is placed and the price at which the trade is actually executed (which could be some time later). As this methodology allows for price fluctuation, it is possible to calculate “negative transaction costs.” The idea of negative costs combined with the fact that most asset managers do not currently track, measure, or store arrival price or slippage costs is concerning for managers in both markets.

Additionally, PRIIPs requires product manufacturers to disclose the likely future performance of the fund under four separate scenarios: favorable, moderate, unfavorable, and stress. The future performance provision runs counter to some U.S. disclosure policies for ETFs. These new PRIIPs requirements make it increasingly difficult for U.S. ETFs to comply with E.U. policies and their implementation has already had practical consequences for U.S. ETF providers. Several key E.U. distribution platforms have removed U.S. ETFs from their menus for lack of PRIIPs documentation and investors have dumped holdings of U.S. ETFs immediately, grabbing the attention of managers. In simplest terms, many U.S. ETFs that previously attracted E.U. investors are now seeing assets outflows.

Another challenge for U.S. funds accommodating European investors, is the requirement they must either register under AIFMD or rely on a concept known as “reverse solicitation” which means investment in the U.S. ETF funds occurs upon the exclusive initiative of the E.U. investors. The very act of producing a PRIIPs KID for investors makes it difficult to suggest you are not attempting to solicit E.U. based clients.

PRIIPs challenges a model where E.U. clients buy shares of U.S. ETFs. To continue to retain or attract E.U. investors in the future, U.S. managers need to consider their distribution options by either expanding their existing UCITS offering or entering the UCITS market.

Which Way Next?

The reality with this new regulation is that it is becoming increasingly hard for E.U. investors to access U.S. ETFs. The markets are separating and at least for the foreseeable future, there are no plans to harmonize the rules. So, what steps can asset managers take now? Start by quantifying the size of the European client-base that their firm is already servicing. U.S. managers who are losing E.U. investors will need to measure the opportunity at hand compared to the costs of adding funds and resources to an existing UCITS line-up or launching a UCITS product line from scratch. For those managers who decide to capitalize on the opportunity present in the E.U., consider the following:

For either route, U.S. ETF providers need to consider the potential for growth given the recent trends in European and cross-border ETF adoption. Consider the following:

Europe’s development of ETFs lags that of the U.S. This may present significant upside for managers as European ETF growth rates are likely to outstrip the U.S. as Europe plays catchup.

The factors that made U.S. ETFs so attractive to European investors are changing. The ETFs offered by U.S. companies traditionally had both liquidity and transparency advantages compared to E.U. ETFs. However, MiFID II brings a similar degree of liquidity and transparency to European ETFs, likely making them more attractive to E.U. investors.

The European advisory market is still maturing, which may accelerate growth in ETFs as the market enters a new growth cycle.

E.U. regulators and policymakers are focused on cost effective investment products for the retail market. ETFs generally thrive in such an environment.

The bottom line? There is growth potential for firms that want to offer ETFs in the E.U. U.S. managers that are watching their E.U. assets dry up have options to counter these negative effects and find new avenues of growth in Europe. PRIIPs has focused the minds of U.S. ETF providers on their E.U. distribution strategy. The question now, is how will you execute?

This article was originally published on BBH.com. BBH has substantial experience in helping firms assess the opportunity in Europe and ultimately launching UCITS Funds and ETFs. We welcome the opportunity to further explore this with you.